Panic! The Story of Modern Financial Insanity

by Rob Horning

26 March 2009

In a sense, panic is an imprecise word to describe the emotion of financial crashes; paranoia better suits.
cover art


Michael Lewis, editor

The Story of Modern Financial Insanity

(W. W. Norton)

Judging by its title and the national mood, it would be easy to mistake this anthology for a look at our current economic malaise. But Panic, compiled and edited by Michael Lewis and McSweeney’s as a kind of philanthropic project benefiting New Orleans charities, collects newspaper and magazine pieces (including several of Lewis’s own) primarily related to several other recent financial crises as well as the one we’re still sorting out: the October 1987 crash, the currency crises of the late 1990s, and the bursting tech bubble in 2001.

Each of the book’s four sections is devoted to one of the panics and features articles from before, during, and after the event. Thus readers are afforded a look at the giddy optimism that precedes a crash, the perplexed dismay during the fall, and the stern postmortems that follow in its wake.

Although it provides a glossary of financial terms for neophytes and biographies of the authors in its last few pages, Panic! nevertheless presumes a fair amount of familiarity with the tropes of financial journalism as well as the context for the events covered. One needs a working grasp of how various markets intersect and what the political conditions were at the time—not only which party controlled what and what their attitude toward the various constituencies in the financial world were but also what foreign policy concerns were pressing.

The changes that took us from the cold war to the so-called Washington consensus (the agreed-upon framework for making former Iron Curtain countries capitalistic), from globalization to the global war on terror, are outside this book’s bailiwick. Though Lewis provides brief introductory essays to each section, these shed little light on who the important players were and what their ideological (not to mention financial) stakes were and how they may have shifted over time. Readers are more or less thrown into the middle of things and left to ferret out much of the significance and the interconnections for themselves.

But if the economic chaos has prompted you to start reading the financial press recently, and you’ve built up the requisite knowledge base—if you can read through references to arbitrage, short-selling and currency speculation without having to pause—this book may well serve as a timely companion volume to the daily news. It helps fill in factual gaps you might have about these momentous events, which financial journalists often gesture toward and use as shorthand for conclusions that have since become conventional wisdom. For example: how the 1987 crash was about portfolio insurance, or how the hedge fund Long-Term Capital Management collapsed in 1997 because of bad bets on the Russian ruble, or how the tech boom was fomented by unscrupulous analysts and novice investors dabbling in day-trading. Reading through these vintage accounts puts some flesh on these skeletons, and lets readers evaluate the process by which the conventional wisdom coalesced—and to what degree that wisdom should be discounted now.

Though some of the tick-tock specifics of these crises past can be perplexing when taken out of context, the book’s conceit works exceedingly well in revealing their fundamental similarities: the myopia, hubris, and outright corruption that technological innovation has served only to intensify. During the so-called Great Moderation, the diminished macroeconomic volatility that current Fed chairman Ben Bernanke outlined in this 2004 speech, much ado had been made about modern advances in risk management—the securitization, derivative instruments, quantitative models, and “dynamic hedging” that were supposed to have rendered dramatic crashes obsolete. Sure, there were slips—that was how the panics chronicled in the book came to be regarded by 2007—but the world markets always regained their footing. Some even speculated that “decoupling” was imminent—that is, that US economy would no longer move in tandem with the rest of the world’s economies, provide greater opportunity for portfolio-protecting investment diversification.

In general, we were presumed to have reached a point at which investors could safely shop for the level of risk they were comfortable with, without fear of unanticipated meltdowns. Just as the fall of the Soviet Union and the end of the cold war was thought to have “ended history”, the Great Moderation allegedly proved that we had mastered inflation and tamed the business cycle, thanks to some mathematical wizardry and the prudent monetary policy doled out in oracular pronouncements from a secular saint, longtime Federal Reserve chairman Alan Greenspan, whose contempt for regulation and easy-money policies of maintaining extremely low-interest rates for an extremely long time this decade set the stage for the egregious abuses in subprime lending and securitization.

Though Panic! includes some coverage of the current crisis, apparently the book was conceived before things really got out of hand. The latest article included in the collection is dated 15 January 2008, and a host of hitherto unthinkable events have occurred since then: the collapse of Bear Stearns and Lehman Brothers; the evaporation of all the major free-standing investment banks; the probable bankruptcy of the entire American auto industry; the economy shedding millions of jobs; home prices tanking; U.S. GDP contracting at a Great Depression-like rate; nearly a trillion dollars spent bailing out the banking system, with the federal government openly considering nationalization.

Even if you read the Financial Times religiously and are following a dozen different economics blogs a day, it’s hard to keep up with everything happening. A book like this could easily seem hopelessly beside the point. (Recently confessed pyramid schemer Bernie Madoff does make a notable cameo in the book, however, in a 1999 piece about wild swings in internet stocks. He complains of the market’s “insanity” and vows not “to relive that event.” Hmm.)

That said, Panic! still seems extremely relevant to our era of financial apocalypse, if only because it shows how the destabilizing systemic problems so prominent in our current crisis have manifested themselves previously in what we now know to be tamer forms. In retrospect, these earlier crises were intimations of what would come, hints that financial regulators and investors alike came to collectively ignore.

For example, quandaries in financial-insurance products continually recur—does writing more insurance assure that the disaster you are insuring against will happen? That seemed to be the case with the feedback loops created by portfolio insurance in 1987, and it also brought down LTCM in 1988. In Lewis’ New York Times Magazine piece on the demise of the hedge fund, he quotes John Meriwether, the firm’s quant-in-chief, explaining how “the more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen.”

This seems to be what happened, in effect, to bring down AIG last year, when it couldn’t cover its losses over bonds it had insured. The company had believed the chances of certain defaults were so improbable that collecting premiums for insuring against them was like taking free money. But those chumps paying that money have had their revenge, for what it’s worth—the US government has been engaged in a rolling bailout for AIG, which had no chance of meeting its obligations.

It’s an economist’s cliché to remark that markets require confidence and trust. This is euphemistic way of saying that economies are basically belief systems; they do not run on a set of deducible laws. They are as inherently unstable as our own capacity to believe without clear evidence.

What is recurrently dangerous about financial insurance products is that they seem to ultimately point the way not to greater trust but to revealing the bad faith among counterparties, peeling back the masks that make credit possible to reveal the competitive cutthroats beneath, functioning with a zero-sum mentality and thriving on the failure of others. In a recent Vanity Fair piece about Iceland’s demise (not included in the anthology), Lewis notes that “one of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.” (“Wall Street of the Tundra” by Michael Lewis.)

In other words, innovation gave the most perceptive analysts a chance to essentially bet against the financial system as a whole rather than blow the whistle. Incentives locked into place that prioritized spectacular failure rather than reform. In a sense, panic is an imprecise word to describe the emotion of financial crashes; paranoia better suits. A crash is that moment when investors realize all too clearly that the people they are dealing with all want to see them fail.

The problems with financial insurance point to another recurring theme, the idea that optimistic financial players systematically fail to account for the possibility of low-probability events occurring. This is the “black swan” critique made famous by former trader Nassim Taleb. Essentially, many banks and firms, operating in an off-balance-sheet netherworld of unregulated finance, were leveraging up to unheard-of levels to seize upon the profits that could be made through bets against what seemed like statistical impossibilities. When these impossibilities proved all too possible, perhaps in part because of their own investments, they were doomed.

And that such a catastrophe in risk management could have struck precisely those professionals whom everyone thought knew better than anyone else how to manage risk has unsettled everybody. What crashes inevitably prove is that no one knows anything, everybody is playing everyone else in a game theory-inflected Ponzi scheme, and the confidence that markets require to run in fact derives from confidence games.

Confidence is ultimately a mystery variable, unpredictably volatile, impossible to manage. Just as this year’s debate about the fiscal stimulus package revolved around restoring confidence, so did the discussions after the earlier crashes. In a piece originally for Fortune about the Asian currency debacle, Paul Krugman explains how fretting about restoring confidence devolves into a “circular argument”. “Any economic plan for Asia would have worked if it had instantly restored confidence. Why not skip the currency board and simply tell people to smile more often?” You can’t force people to be confident, and desperate plans designed to that end are doomed to fail from the outset, as they seem to signal we should be even more afraid than we are.

Manufacturing confidence is mainly a matter of salesmanship, not of regulation. Just as no set of rules can resolve the latent trust issues involved in trading, no regulatory framework can ensure the full faith and confidence of all participants. The rules are always made to be broken, or if not broken, then changed. The safety features put in after calamities are later disabled or ignored. And as this cyclical process advances, the markets become increasingly characterized by greed and cynicism—no one really believes the alibi for whatever bubble is inflating; they just want to get rich quick and leave some bigger fool who’s late to the game with the losses.

But what Panic! ultimately focuses on, albeit in an indirect way, is what role the press serves in the business cycle. Are journalists the ultimate salespeople for financial frenzies? The ultimate cynics, who know better but feed the hype anyway? By its very nature, the book is ambivalent about these questions. As an anthology of clips, it inherently testifies to the overall importance of the business press, yet at the same time, it is designed to expose financial journalists’ fickleness and inaccuracy, revealing the way reporters end up getting captured intellectually by the subjects they report on.

Lewis has at times been less ambivalent. In his postmortem on the internet bubble, he writes that “the media were happy to hold everyone but themselves accountable for the internet frenzy” and points out that the Wall Street Journal and the rest of the business press was “once interested mainly in fantastic success and added its share of furl to the internet boom” but after the crash was “mainly interested in failure.”

Such criticism seems warranted but a bit beside the point. Commercial newspapers are just out to make a buck, like any bubble investor. And in the end, their reporters have no other imperative than to provide a product that will sell. If that agenda serves the truth as well, that is somewhat incidental.

But Panic! shows how a kind of neutral perspective emerges from the morass as time passes. As the journalism becomes part of the historical record, it loses its commercial context and becomes a mere document, a crystallization of various competing interests and ideologies which are always ever in flux, like the random walk of markets themselves.

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